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Will All That Fund Sizzle Turn To Smoke?

Mutual-fund investors have plenty of reasons to be merry as 1995 draws to a close. The average equity fund turned in a total return of 24.2% for the year, compared with -5.3% a year ago. And bond funds were no slouches, with taxable funds gaining 14% and tax-free funds rising more than 15%. A Scrooge could note that actively managed mutual funds didn't beat the 37.6% return of the Standard & Poor's 500-stock index. But the 1,667 U.S. diversified equity funds, which by their nature tend to track the indexes, are up 31%. In fact, almost half of the mutual funds in Morningstar Inc.'s 6,026-fund universe had gained 30% or more as of Dec. 8.

The mutual-fund investors with the most to celebrate are those in technology funds, the year's top performers. The average total return of tech funds is 44.6%, including reinvestment of dividends and capital gains. Although tech funds have given up some gains recently, their returns still beat the 41.5% gain of health-care funds and the 40.3% return of funds focusing on financial stocks such as banks and insurance companies.

Small-cap funds, up almost 30%, were also big winners in the 1995 fund derby. But many of them were outperformed by the larger aggressive growth funds. Fifteen of the 25 largest equity mutual funds weighed in with returns topping 30%. The best return was in the $14.8 billion Twentieth Century Ultra Investors, an aggressive growth fund that moved up 40.8%, thanks to some smart big bets on technology. The $17 billion Washington Mutual Investors fund came in second with a 39.3% return. And the $53.8 billion Fidelity Magellan fund grabbed third place with a 38.2% gain.

"PLACE TO BE." Small-cap mutual funds may give their larger-cap cousins a run for their money in 1996. Investment managers expect the NASDAQ Combined Composite Index, home to many small-cap stocks, to continue outperforming the large-cap indexes. Some small-cap stocks did beat the megafunds in 1995. Garrett Van Wagoner, fund manager for the $563.5 million Govett Smaller Companies A Fund, steered it to a 65% return. That means that it stands to become the best-performing small-company fund for three straight years. If there is continued low inflation and low real growth with no recession in 1996, "small-cap growth is the place to be," says Van Wagoner.

Van Wagoner set the stage for his fund's stellar return by selling his 17% holding of chip stocks at midyear. He put half the money in Internet stocks and the rest into data communications and software issues. His Internet strategy includes selling half of a holding when it doubles in price. Van Wagoner remains bullish on Internet stocks. "They seem incredibly valued, but the growth potential of the area is as big as I've seen in any area," he says. "Over the years, I've found that the best companies and the best groups are always expensive."

In 1996, the 40-year-old Van Wagoner is striking out on his own and starting a family of no-load funds. The Van Wagoner Funds will premier with micro-cap, emerging growth, and mid-cap fund offerings in early 1996. The emerging growth fund will be managed similarly to the Govett Smaller Companies Fund.

The grand prize among the top-performing tech group goes to the $1 billion Fidelity Select Electronics Fund, which is managed by Marc Kaufman. The strength of semiconductor stocks was a big contributor to the fund's total return of 74.4%. Chip stocks have taken a beating lately, however, with many 30% to 50% off previous highs. The fund's net asset value, in fact, is down 15% from its September high.

Kaufman has repositioned the fund to take advantage of companies that offer proprietary technology products. "Because they provide products that fill specialized niches...these companies may be well-positioned to grow earnings whether or not the rapid growth in the semiconductor industry continues," he says. Two such holdings are Atmel Corp., a maker of memory and logic chips, and Linear Technology Corp., which produces so-called linear integrated circuits.

GROWTH AHEAD. Tech stocks also fueled the performance of the second-best-performing fund. The $40 million Alger Capital Appreciation Fund racked up a 73.5% return by having more than 50% of its assets in tech and by leveraging--borrowing against about 20% of its assets during the year to buy more stocks. Fund manager David D. Alger beefed up on chip stocks during 1995 but has since trimmed them to 14% of the fund. Alger isn't using any leverage currently. His largest positions include computer stock Altera, Canadian pharmaceutical company Biochem Pharma, retailer Gap, and telecom company U.S. Robotics.

Growth funds are expected to be strong performers in 1996. Alger expects growth stocks to have a very good year compared with the broad market. "Growth stocks underperformed the market in 1993 and 1994, so they have a lot to go on the upside," he says. Jay Schabacker, editor of newsletter Mutual Fund Investing, is also high on the prospects for growth funds as well as equity-income funds. He likes the T. Rowe Price Equity Income Fund, which is well-represented in areas he favors, such as financials, utilities, and health.

Stellar returns from tech funds have investors wondering if they should take profits. Alger feels that the outlook for tech is bright. "What you're seeing now is a blip where people got overexcited in some areas of the technology industry, and there has been a slight slowdown," says Alger. "These stocks are extraordinarily cheap...they have retrenched a lot."

Gerald Malone, co-manager of the $381 million Alliance Technology A Fund, up 51%, is also a tech bull. "Investors are concerned about whether tech is more sensitive to an economic slowdown today," he notes. "But you need to go beyond that and realize that the worldwide penetration of the consumer market by technology is still in the early stages." While expecting slower rates of growth from tech stocks in 1996, Malone and co-manager Peter Anastos like semiconductor stocks, which they think will benefit from strong unit growth in personal computers. They also like wireless communications stocks, although they cite short-term concerns about the rate of growth in the cellular subscription base. Other stocks among their favorites are service companies such as Electronic Data Systems, First Data Co., and DST Systems.

PICKUP OVERSEAS? Investors who ventured abroad missed out on the biggest returns in 1995. International equity funds returned, on average, 6.3%. Diversified emerging-market funds were the worst-performing group, down 5.7%. Pacific stock funds gained less than 2%. Funds that focus on European stocks, however, were up 13.2%. Better performance came in international bond funds, which gained 15.5% thanks to a weak U.S. dollar.

In 1996, the international equity funds may perk up. In the last two weeks of November, there was a small pickup in the flow of money into international equities after two straight months of outflows, notes Robert Adler of AMG Data Services, which tracks weekly fund flows. Kurt Brouwer, of San Francisco investment advisory Brouwer & Janachowski, says Europe and Japan have "explosive potential" but need a catalyst to produce the returns that their markets are capable of. Bullish investors might look into the Warburg Pincus Japan OTC Fund, which editor Schabacker of Mutual Fund Investing recommends for aggressive accounts. The risky fund owns the smallest of the small-cap Japanese companies.

Where did mutual-fund investors place their bets in 1995? Equity funds received a steady inflow, with $97.4 billion in net new cash flow as of October. Robyn Tice, a spokeswoman for Fidelity Investments, says November may turn out to be the strongest month of the year for sales of domestic equity funds. As of Nov. 24, Fidelity had $2.4 billion in net sales of domestic equity funds for the month. That compares with $638 million for all of November, 1994.

Taxable-bond and income funds, in contrast, saw $7.4 billion flow out the door. But after four months of heavy redemptions early in 1995, the funds had four straight months of inflows as of October. Much of that has gone into high-yield bond funds, which had an average return of 15.3% for the year. That fell short of convertible-bond funds' 20.1% return and the 16.7% return of government bond funds investing in Treasuries.

BOND ANOMALY. One of 1995's big surprises was the rally in bonds. Low inflation and declining interest rates led to some spectacular returns at funds investing in long Treasuries. The top-performing bond fund, $565 million Benham Target Maturities 2020, ended the year up 56.7%. Fund manager David Schroeder invests in zero-coupon bonds maturing in 2020. "Performance has been strong because as interest rates decline, the fund does well," he says. Next year may not be so kind: "The bulk of the decline in rates is probably behind us. I wouldn't expect price appreciation to be as big a part of the fund's total return in 1996."

Municipal bond funds also did well. The top-performing muni fund, California Muni, gained almost 33%, compared with a 20% loss in 1994.

The worst-performing bond fund was an anomaly. Astra Adjustable Rate Securities IV lost 37.5% in value. The only negative returns of the year, in fact, were in a series of Astra funds. They are an unusual case: In 1994, the funds invested in private-issue adjustable rate mortgages (ARMs), instead of safer government-backed ARMs. Credit quality problems arose, fund net asset values slumped, and shareholders started redeeming. That started a vicious circle as the fund was forced to sell illiquid securities at distressed prices.

After such a gangbuster year in the stock and bond markets in 1995, there's a strong chance that 1996's returns will pale by comparison. At least, that's the way a Scrooge might think. More sanguine investors might raise a glass to an outstanding year and look forward to a more subdued bull market.By Suzanne Woolley in New York